The stock market is now the most overvalued it has been in history, save the period leading up to the 1929 market crash. Even factoring in the Trump tax cuts, stocks are roughly 30% overvalued. Of course, that’s what happens when central banks around the world flood the markets with $14 trillion in liquidity, crushing bond yields and forcing everyone into riskier assets to chase yield.
This is a long way of saying you should be very afraid, even though those words are going to fall on deaf ears because the markets can’t seem to go down. Trust me, I’ve been investing for 23 years and markets go down. Markets like these go down lots and lots.
It’s called a market crash. It may be a slow-motion market crash, but it’s a market crash nonetheless.
A Market Crash Is Coming
One of the approaches I take with The Liberty Portfolio, my stock and options advisory newsletter, is to build an all-weather portfolio heavily weighted toward non-correlated investments. In addition, the Liberty Portfolio has a “market crash protocol” that dictates how to take advantage of the market when the bottom falls out… which it will.
So you are probably sitting there looking at the lovely gains in your portfolio over the past few years. Even income and retirement investors, having been forced out of bonds into the equity markets, are probably thinking that they will never go back to bonds. Why should they?
You should be very afraid.
If you don’t have a non-correlated investment portfolio, then at least prepare yourself for some form of market crash. Eventually, the central banks are going to have to unwind all that juice they pressed into the bond markets. When that starts to happen, you are going to need to do several things.
How to Prepare for the Impending Stock Market Crash
The first goal is to preserve capital. If you don’t have stop losses set on new positions, you should. Always set a 7-10% stop loss in the event you’ve gotten your analysis on a stock wrong.
Next, if you have any new positions or swing trades in progress — or any kind of covered or naked puts or calls — close out all those positions. You want to raise cash.
If you are in the market for at least another ten years, you can hold onto your big winners. The market will recover and there’s no need to take the capital gain. However, if you have big losers, sell them. Things will only get worse and you want to harvest losses to offset gains at some point.
The best bet you can make is to short some aspect of the market. If things start to break down, you can start to short in increments to hedge your portfolio. There’s no need to go all in at once.
Ways to Hedge Your Portfolio
You can short the S&P 500 index using the ProShares Short S&P 500 (NYSEARCA:SH). This means you have gone short when the market as a whole is going down. You can add or subtract to it as you please.
How much should you short? One rule of thumb is to hedge 20% of the total value of your portfolio. But if we are in a full blown crash, you can hedge more.
You can also hedge by shorting the NASDAQ 100 using the ProShares Short QQQ (NYSEARCA:PSQ). Those big high-flying momentum stocks and unicorns make up the majority of this index, so that should serve you well.
If you wish to widen your hedge, try shorting the Russell 2000 using the ProShares Short Russell 2000 (NYSEARCA:RWM). The RWM ETF shorts the 2,000 smallest stocks in the market. In a crash, worried investors sell smaller stocks first, since the perception is they carry more risk than blue chips.
Most of all, keep a cool head!
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 1,800 articles on investing. Lawrence Meyers can be reached at [email protected].